The costs of de-risking your pension too early

An overly cautious investment strategy in middle age can shrink the final value of your fund

It’s the pensions oversight that could cost you thousands. The target retirement date on your annual statement letter may seem just a formality, but ignore it at your peril. A retirement date set too soon could mean you lose out on valuable investment returns.

The consumer group Which? says that more than £100 billion is invested in so-called lifestyle pension funds, which choose the investment approach for your savings based on your age: riskier for when you are younger, lower risk when you are older. On these direct contribution pension funds the provider selects a default retirement age, usually 60 or 65, and the fund begins dialling down the risk between five and fifteen years before you reach that age. Workers aged 50 and over will be gradually moved into the safe haven of bonds and out of the stock market.

This strategy is called a “glide path” and is designed to lock in investment returns you have made while younger, because you are less likely to lose it all if you move into safer investments. However, you will not make as much return on your investments either. Which? researchers found that a £200,000 pension pot was worth 18 per cent less when subject to a typical ten-year glide path. This equates to £76,250 less than a pension pot of the same size that remained in shares.

These lifestyling, or default, funds are used in up to 85 per cent of workplace schemes, according to a 2015 study from the Pension Policy Institute.

The World Economic Forum has warned of a massive savings gap with people failing to save enough into private pensions to fund later life.

Kate Smith, the head of pensions at Aegon, an insurer, says that lifestyle funds came from the days when it was assumed that a person would retire at 60 or 65, take a quarter of their pension savings as a lump sum and buy an annuity with the rest. That model has been turned on its head by the 2015 pension freedoms, which removed the requirement most people had to buy an annuity. The numbers of people who choose an annuity has fallen from 400,000 a year to 80,000. De-risking too early may mean a poorer retirement for those who do not want an annuity, and instead choose to stay invested and take regular income from their savings, a strategy known as drawdown.

One of the problems arises when you reach your target retirement date and realise that you want, or need, to keep working. Your lifestyling pension fund will have already been in a de-risking mode for up to 15 years, supressing the investment returns you could have made.

“I am not saying investors should take more investment risk than they are comfortable with, but they need to understand that by choosing lower-risk options they may be increasing the danger of running out of money in retirement. They certainly shouldn’t make that choice automatically, without thinking the issue through,” says Matthew Yeates, the quantitative investment manager at Seven Investment Management (7IM). His company is calling for the new government to highlight the issue and prioritise retirement education.

Investment risk is not the only thing you need to worry about, he adds. Your longevity and unexpected expenses are also risks. For some people, de-risking their fund will be appropriate, while for others a slower pace of de-risking than the default will be more suitable.

Ms Smith says that the target retirement date chosen by pension funds can be arbitrary and often seem out of step with modern work patterns. “A retirement age of 65 might seem appropriate when you are 35, but very few people retire on the day pension funds expect them to. People need to be realistic about the age they want to retire. Fewer people are going into retirement early unless they are forced out due to ill health,” she says.

Those in their forties and fifties can prevent problems by taking a look at their pension fund and considering what their plans may be. Andy James, the head of retirement planning at Tilney, an adviser, says: “If you will be looking to take an annuity, then a lifestyle fund may well be suitable, although even here it may not be structured in a way that would meet your risk profile. If you will be looking to take the funds as a cash sum at retirement, it is probably going to be sensible to have completely de-risked the investments by that time. A lifestyle fund will not do that.”

He adds that those who want to go into drawdown “may well be wise to maintain a fair level of investment risk right up to and beyond retirement age”.